Risk Pricing Under Gain-Loss Asymmetry

Abstract

Asset prices are derived in closed-form in a framework where agents evaluate risk with gain-loss asymmetry: losses relative to a reference point incur discontinuously more disutility than comparable gains. This asymmetry has a dual impact. First, a level effect: risk prices are made higher by the kink in the preferences. Second, a cross-sectional effect: the pricing of risk is higher (lower) for safer (riskier) assets, so expected returns increase non-linearly with the risk-exposures. This second effect, a crucial departure from standard smooth utility models, is weakened by lower specifications of the reference point and by higher volatilities in aggregate risk.